UK financial markets are experiencing a bout of volatility due to a rise in political uncertainty. In this note we describe what’s happening, and what this might mean for economic policy and markets in the coming months.

How did we get here?

On 7 May, the Labour Party suffered heavy losses in local elections. As a result, Sir Keir Starmer is facing mounting pressure to step down as the leader of the Labour Party and as prime minister.

Though not as dire an outcome as some polls had suggested, Labour lost close to 1,500 seats in English councils, four seats in the Scottish Parliament, and 35 seats - along with overall control - in the Welsh Senedd.

While it was Reform UK that emerged as the apparent winner, there is speculation that Labour may look to stem the flow of votes to the Greens and other left-leaning parties by replacing the relatively centrist Starmer with a leader willing to shift the party's direction to the left of the political spectrum.

At some point investors may start to question what a Reform-led government would mean for policy and the UK. This far away from the general election, Reform UK has no need to pin itself to a specific policy agenda so that will only be revealed in the coming years. Right now, the market is focused on how the Labour Party will evolve in the period up to the next general election.

Relying on the kindness of strangers

The biggest constraint on both the current, and any prospective, government to meaningfully change policy is the UK fiscal position.

At face value the UK government isn’t the worst offender when it comes to its level of debt. UK debt is over £3 trillion, which is roughly 100% of GDP. But France, Italy and the US all have levels of debt that are higher relative to the size of their economy.

However, there are certain issues that make UK government bonds more vulnerable to market stress.

The first and most problematic issue is that an increasingly large amount of the UK’s outstanding debt stock is now owned by overseas buyers. When a lot of outstanding government debt is owned domestically, governments can use regulatory levers to influence the behaviour of buyers. This option isn’t possible when buyers are overseas and making decisions based on the relative attractiveness of the UK to its global peers. High foreign ownership is why former Bank of England Governor Mark Carney described the UK Gilt market as ‘relying on the kindness of strangers’.

On top of this issue, the UK doesn’t have implicit protection from being in the eurozone in the way Italy and France do. Global investors are mindful that if France and Italy run into fiscal trouble, they will likely have the support of relatively low-debt Germany, and also have the backing of the European Central Bank’s Transmission Protection Instrument, which can intervene in sovereign bond markets.

Another problem is that a relatively large proportion of UK debt is index-linked. As a result, cost shocks that push up inflation, such as those experienced in 2022 and today, automatically push up the government’s borrowing costs, just at a time when the government will be under pressure to ease fiscal policy.

All these factors seriously constrain the ability of the UK to borrow more than it currently plans. Even if a shift to the left in government is combined with a commitment to raise taxes to spend more, bond investors are unlikely to react favourably given the fact that the UK tax take is already the highest it has been since 1950. And the proportion of tax taken from the highest earners is already higher than it’s ever been.

Of course, global investors will always be willing to lend to the UK government, but the question is at what interest rate. The amount of government revenue being used to service the current debt was already around £110 billion in fiscal year 2025/26, and this further rise in interest rates will put yet more pressure on the government's ability to service the debt.

Tax changes may be one reason growth has been so low in recent years. The rise in the tax gathered from employer national insurance contributions in the first Labour Budget has, for example, coincided with a period of stagnant employment. Even a ‘fiscally-neutral’ shift left may still therefore concern Gilt investors.

Market implications

The 10-year Gilt yield is now over 5%, and the 30-year Gilt yield is edging towards 6% – its highest level since 1998.

The rise in borrowing costs isn’t all due to the domestic political situation. Global government bond yields have also risen this year due to the conflict in the Middle East pushing up inflation and changing the trajectory for central bank interest rates across the world.

Similarly, the reason why bond yields have risen meaningfully more in the UK than in Germany or the US isn’t entirely due to political risk either. It partly reflects the fact that UK inflation tends to be more persistent after a cost shock, which would mean higher short-term rates for longer in the UK than elsewhere.

Nevertheless, some of the increase in Gilt yields does reflect a political risk premium. And there is evidence of a greater risk premium in UK stocks too. Again, it’s somewhat hard to disentangle from the impact of the Middle East crisis, but UK small caps, which more closely reflect domestic prospects, have underperformed the more international UK large cap index by a much higher margin than has been seen elsewhere.

The political turmoil will make the job of the Bank of England even more challenging in the coming months. The Monetary Policy Committee is already struggling to navigate the correct response to the Middle East crisis. In our view it is likely to make the Bank even more hesitant to raise the policy rate and aggravate the long end of the yield curve. We continue to believe the Bank of England will hold interest rates steady for the remainder of the year.

Conclusion

It is not surprising that the stagnation in UK living standards is prompting the UK population to question its political leaders. But any attempts by the government to spend more may prove counterproductive if it causes financial market instability and further stimies economic growth.

The coming weeks may well implicitly involve a difficult dialogue between politicians and global bond investors since the UK is very much ‘in hock to the bond market’. However, as with most periods in which politics clash with economics, this situation will create opportunities for investors willing to buy assets and sit through volatility in the expectation that sensible economic outcomes will eventually be reached.